Investing Advice from Warren Buffett

“And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Warren Buffett is a noted multibillionaire investor who runs Berkshire Hathaway, which is essentially a company that owns other companies and profits from their profits. The other companies are selected based on his and his team’s stockpicking and research. Each year he writes an annual letter to his shareholders which often contains investment advice that others can and should use for their own benefit. This particular quote comes from his 2004 letter.

The last part of the sentence, “…be fearful when others are greedy and greedy only when others are fearful”, is often quoted in the financial news, which leaves out the first phrase regarding attempts to time the stock market. However, the context is important.

Warren Buffett himself doesn’t try to invest based on his outlook on future price movements. He researches companies and gets to know them before making a decision about purchase. (For those like his wife who are uninterested in this very in-depth investing process, he has suggested simply buying an index fund of large cap, or large company, stocks for the portfolio.)

The stock market is based on millions of trades a day with thousands of people and computers actively making decisions. We know the long-term averages of the markets, but in the short-term, it’s not possible to know what the market will do given all this activity, and so trying to predict its motions is an exercise in futility.

Many investors, however, do end up trying to time the market, whether they realize what they’re doing or not. When market sentiment is up and the market is growing, people feel more comfortable about putting their money to work in the market. It’s like going to restaurants only when there are plenty of people already inside, because if everyone is staying away from a place, then there must be something wrong with it, right? At some point Fear Of Missing Out (FOMO) kicks in, and investors buy willy-nilly into the latest craze. This was very clear in the house-buying spree of 2006-2008, because people with lower incomes were able to buy high-priced homes, assuming that house prices would continue to rise and they could refinance when their interest-only loans came due with higher equity. FOMO was also on display during the dot-com boom in the late 1990s, when every online company was going public and everyone wanted in on the action, no matter how unprofitable the dot-com would be in the future.

And then the crash happens, and everyone is scrambling to get out of the market. As it drops, no one wants to be the last investor standing, and so they lock in their losses by selling lower than what they bought the position for. This behavior is perfectly natural given human nature, but it causes more pain and angst than is necessary. It can destroy retirement savings if securities are bought high, when everyone is piling in to a rising market, and then sold low when everyone is trying to sell out of their losing positions.

Buffett is suggesting that if you’re going to use the herd as your yardstick for buying and selling (which is not the best idea anyway – better to have a rules-based plan for trading) that your trades be against the herd. When the market is greedy – everyone is buying without paying attention to what they’re buying, as long as it’s in the favored sector – you should be fearful. That means avoiding buying with the herd, and you might even sell some positions in that sector if you have gains. When people are fearful – selling everything off because the market sentiment has turned – that’s the time to start buying everything. This is true, but much easier said than done.

So, when everyone was buying dot-coms at a fever pitch in the late 1990s, smarter investors would have been fearful – maybe selling tech positions they did have at the ridiculous market valuations, and certainly not buying anymore. FOMO is a real phenomenon, though, and I know from personal experience: I was finally emotionally ready to buy a house in 2006/7. I was reading articles in the Wall Street Journal about couples with children who made less than I did buying houses for twice as much as I would have ever dreamed of paying on my salary. If them, why not me? I was definitely suffering from FOMO and maybe a little real estate envy! However, I lived in Los Angeles at the time, and I could not bring myself to pull the trigger on a house, because it was so obvious to me that we were in the middle of a housing bubble. Even though major economists said we weren’t, I just couldn’t overpay for an asset I was pretty sure was going to fall significantly at some point. I was right, and boy did I make the right decision! But it was also really hard to ignore all the home-buying that was going on around me and being reported in the news.

And if resisting when the market is going up is difficult, going against the herd when the market bottoms out is even tougher. The floor of the 2008/9 market drop occurred in March 2009, but no one could know that at the time. What people did know was that stocks had dropped by close to half, and many investors had locked in their losses by selling. Getting back in at the bottom is terrifying – worse than going to a completely empty restaurant, and people won’t even do that. But that’s being greedy when others are fearful.

Fortunately, there is a way to avoid these swings between greed and fear. Choose an asset allocation that you can stick to through boom times and bust, and stick to it. This means having some cushion against the stock market for your near-term expenses, and also stocks for the long-term since they hold up best against inflation. You’ll need to rebalance back to your allocation roughly each year or if your portfolio changes significantly due to market fluctuations, and you’ll have rules about buying and rules about selling that you stick to. If everything is automated, you don’t even have to spend much time with your portfolio, so you don’t have to watch it go up and down and down and down and up again, but can let it grow without too much interference. For most people, who don’t have a career in investing, leaving the portfolio alone as much as possible is usually the best bet.